Toughening Corporate Disclosure Rules After Enron

Transcript

MR. ROBERT HAHN: Good morning ladies and gentlemen. My name is Bob Hahn.

I have both good news and good news. We're going to be televised on C-Span this morning, and the event is also being WebCast on the Internet, providing live streaming audio and video of the event to users who click where indicated on the main Brookings homepage which is www.brookings.edu.

The full video of this event is also going to be archived on the Brookings web site so you can access it later, along with a full transcript which will be posted on the Brookings web site.

Those of you watching and listening to the live WebCast or to C-Span would like to ask a question of the panelists, you can send your questions via e-mail to question@brookings.edu, and we'll try to include as many of your questions as time allows.

For those of you in the audience we also have some rules. I'd like to ask you to please raise your hand if you have a question and when you're recognized wait for the mike to reach you and stand up and ask your question and identify yourself.

With that, let me mention a couple of items directly related to the conference.

First, I'd like to thank Marcia MacNeil, Kai Bode and Erin Layburn and Cumber Hussein for helping to organize this event.

You'll note in the folders that you have a very special blue card. If you fill out that blue card I promise you that you'll get all the news that's fit to print from the AEI-Brookings Joint Center. We include all of our materials on our web site in their entirety, and that includes a new book edited by Kip Buscusey which I'd commend to you called "Regulation Through Litigation".

Speaking of books, we're planning on releasing a book that is partly related to today's conference and has an ambiguous title, or perhaps a title that you can shape during this presentation. It was initially "Corporate Disclosure after Enron", I'm told, but I'm also told that the authors are considering changing the title to something like "Fuzzy Numbers", recognizing that Enron is not the only issue under discussion today. The book's going to have four contributors including two of today's panelists that I'll introduce shortly.

In one word, the topic of this conference is Enron. To expand on that a little bit, why did a high-flying company in a high-flying economy suddenly collapse? And why has that collapse been followed by earnings restatements by companies like WorldCom and Xerox, and you can fill in the blank for other companies that have billion-dollar glitches that appear in the papers almost daily.

I think the answer to that is information. Individual investors and markets generally need reliable information in order to price equities. When that information is found to be unreliable, people lose confidence in equities and stock prices decline, as many of you are well aware if you look at your 401K statements. If the loss in confidence is widespread, then the overall market can decline substantially.

One important source of economic information on business comes from corporate disclosures that are verified by independent auditors. In the U.S. the Financial Accounting Standards Board is charged with setting the standards that ensure the information released by corporations is transparent and accurate. With the wave of recent restatements, lawsuits and government investigations, many are questioning whether those standards or perhaps the accounting industry generally need to be subject to new regulations or standards.

Some have proposed that the U.S. adopt the standards used by the International Accounting Standards Board, and I suspect we'll hear a little bit more about that today. Or that firms be allowed to choose among standards, thus fostering some degree of, dare I say it, competition. Others have proposed a new regulatory body reporting to the Securities and Exchange Commission that would oversee the auditing profession or for that matter a beefed-up SEC.

Some have argued that auditors should be prohibited from doing other consulting work or that companies should be forced to rotate auditors. others have focused on the special-purpose entities abused by Enron. No shortage of solutions out there, as you can see, and for that matter definitions of the problem.

Our panel today is going to define the nature of the problem as well as offering some creative solutions. They'll offer their own suggestions for changing corporate disclosure rules as well as the rules surrounding corporate government.

You, the audience, will also be playing a very important role after out initial presentation. My role as a kind of de facto MC will be to keep our experts within their 15 to 20 minute presentation times, and in the interest of economizing on time I'm going to introduce our three expert speakers/panelists right now.

George Benston is the John H. Harlan Professor of Finance, Accounting and Economics at Emory University in Atlanta, Georgia. Before coming to Emory in 1987 he taught at the University of Rochester and the University of Chicago, visited at the London School of Economics, London Business School, Hebrew University, and the University of California at Berkeley, and was the John M. Owen Distinguished Visiting Fellow at Oxford University. He's a member, among other things, of the Shadow Financial Regulatory Committee and the Financial Economist Roundtable.

Bob Litan, my co-conspirator at the Joint Center who puts on a lot of these events with me and we work hand-in-glove, is Co-Director of the AEI-Brookings Joint Center. He's also Director of the Economic Studies Program at Brookings and Cabot Family Chair in Economics there, and Co-Chair of the Shadow Financial Regulatory Committee. Bob co-edits the Brookings Wharton Papers on Financial Services and Emerging Markets Finance. Formerly he was Associate Director at OMB, Deputy Assistant Attorney General in the Anti-Trust Division of the Department of Justice, and a Regulatory Specialist for the President's Council of Economic Advisors. Bob, I'd go on and on but I'd have to charge you for your time, so suffice it to note that he has many recent books and you can find them on the Brookings web site and also the Joint Center web site.

Katherine Schipper was appointed to the Financial Accounting Standards Board in September of 2001. Prior to joining FASB she was the L. Parmer Fox Professor of Business Administration at Duke University's Fuqua School of Business. Ms. Schipper has published research papers on a range of accounting and corporate finance issues and has been the recipient of several grants and awards including the American Accounting Association's Outstanding Educator Award. She has served the American Accounting Association as President and as Director of Research and as President of the Financial Accounting and Reporting Section. She was a member of the FASB's Financial Accounting Standards Advisory Council from 1996 to 1999, and she has been a member of the Board of Directors of MDT Corporation and of the Acorn Fund.

In short, you can see a very distinguished panel with experience in both government and the private sector as well as academia.

With that, I'd like to turn it over to my colleague Bob Litan for his presentation. Thank you.

MR. ROBERT LITAN: Thank you very much.

We're here today to foreshadow the main tentative conclusions of a book that isn't yet finished and doesn't even have a title yet, as Bob pointed out, because we get a new scandal it seems every week. So we're still working on that. But we thought given all the things that are happening we would roll out the first chapter, or draft first chapter, and then let people take potshots at where we're headed.

George Benston my colleague, in a minute, one of three other co-authors of this book, is going to talk to you specifically about what we believe went wrong in Enron and also what is wrong, we believe, potentially with the current accounting standards setting process in the United States. I'm going to give you some brief overview points that lead into that so let me start right away.

Point number one. You've seen all these earnings restatements — WorldCom, MCI, Xerox, Enron, Waste Management, Sunbeam. We've got at table in the draft chapter, and unfortunately those of you on TV can't see it, but those of you in the audience have it. The key point that I want to stress as the opening remark is that the main flaw in virtually all of these cases is not that the accounting standards or even the auditing standards were somehow defective. The main problem was enforcing the standards. In other words, the auditors didn't do their job.

Now there are some slight exceptions. George is going to talk to you about an issue that has not received the attention it deserves in the media, and hopefully we're going to correct that today, an issue called fair value accounting. All the attention of the media on Enron has been focused on the special purpose entities or these off-balance sheet entities that Enron used to finance itself. But the real problem that George is going to talk to you about is fair value accounting.

But back to the first point, the standards are not the issue, in our view. It's the enforcement of the standards. That's point number one.

Point number two. Even though the standards are not at the core of the problem, we're not entirely happy with the way current accounting standards are set in the United States. As Bob referenced, we have something called Generally Accepted Accounting Principles, they're set by the Board that Katherine sits on, FASB, and FASB's been doing this job for roughly 30 years. We have basically three problems with FASB.

And by the way, in speaking of these problems in no way do we mean to criticize the professional integrity and competence of people that sit at FASB. We have great respect for Katherine, I personally do. I have great respect for the new Chairman of FASB, Bob Hertz, who is a good friend of mine.

But we think the core of the problem with the way GAAP is set — Generally Accepted Accounting Principles — is that FASB has a monopoly on standard setting. Monopolies, just as in the private sector, they can have the same problem in a quasi-public role. Monopolies can be too slow in adapting to change. They can end up writing rules that are overly complex, and we talk about that in our book. And in this setting in the United States, they can be subject, too subject to political influence. Because at the end of the day while FASB is an independent organization, it reports to the SEC and the SEC essentially reports to Congress, and there's a well-known episode in the 1990s where narrow political interests working through the Congress essentially stopped FASB from doing its job which was to expense stock options which we believe ought to be expensed, and FASB was more or less stopped dead in its tracks.

So we're not entirely happy with the way accounting standards are set in the United States, and that leads to the next point, number three, what should be done about all of this?

Well, if the core of the problem is enforcement and also monopoly standard setting, that suggests what the solutions are. We've got to fix enforcement and we've got to do something about the monopoly problem in setting standards. So let me take the monopoly issue first.

We advocate in our book a variety or various ways of introducing more competition into standard setting. As a practical matter there are only two standards out there left in the world. The United States standard, which is GAAP, and the International Accounting Standards called IAS. That's set by this body called the International Accounting Standards Board which is located in London.

Now there are some people that think that you cure all these problems by essentially eliminating FASB and going to International Accounting Standards, have one set of standards set in London. It will give Katherine great comfort, or at least some comfort to know that we are not suggesting the elimination of FASB. We do not endorse the rush to a single accounting standard for reasons I'll get to in a minute. Instead, we talk about three or four different forms of competition between GAAP and IAS.

One version is what we call unconstrained competition where firms in the United States or elsewhere, for that matter, could decide which standards they want to abide by, either GAAP or IAS, without any constraint.

A second version would be what we call a constrained competition. Let the firms choose, but only after the differences between FASB and IAS are somewhat narrowed.

A third version of competition we call limited competition, would be to let firms choose either IAS or GAAP but require them to reconcile for investors the major differences between GAAP and IAS.

Under current law if a foreign company wants to register in the United States it's allowed to use International Standards, but it has to reconcile all its differences between GAAP and IAS. American companies are not allowed to use IAS. They use GAAP. But the reconciliation requirement applies pretty much universally to foreign firms.

In our limited competition model, we talk about a variation of this which would say the reconciliation would only apply to what we would call material differences between the international rules and U.S. GAAP.

Finally, a fourth version of competition is something called mutual recognition. Mutual recognition says, and it's particularly pushed by many in Europe. It would say we in the United States have to recognize International Standards for our European companies coming to the United States, and likewise, Europe would recognize GAAP over in Europe.

Now I want to stress to you, this is a very limited form of competition, this mutual recognition, because it grants monopoly status or preserves monopoly status for both International Accounting Standards and U.S. GAAP, but it just simply recognizes one or the other, depending on which country you're in.

Depending on how much competition you allow, we argue that the more competition the better. The more competition, the more up-to-date the standards will be, the less complex they'll be, and the less political influence there will be. In fact if you have truly unconstrained competition we argue that what will happen is that the marketplace will discipline companies that pick the wrong standard or pick a weak standard.

So let's take the expensing of stock options as a perfect example. Let's suppose the International Standards writers go and require expensing of options which is pretty much guessed as to what they're going to do, and the Americans don't do that. We believe there's a good chance that institutional investors and other investors will punish companies that choose U.S. GAAP and do not choose the better rule, the International Accounting Standards. But in any event, the key point is we'd rather have the marketplace decide this rather than some arbitrary fiat.

What's the main argument against competition? The main argument is investors will be confused. You'll have some companies reporting under one standard and another company reporting another standard. How will we be able to compare apples-to-apples, earnings from one company to another? Our answer is that if there's a demand by investors to have some kind of apples-to-apples comparison, there will grow up a third party independent industry, whether it be analysts on Wall Street or independent analysts, who will do these reconciliations and will basically publish earnings that are apples-to-apples comparisons. They may not be ideal, they may not be perfect, but there will be market pressure on companies to produce enough information so that these third party analysts will be able to do these reconciliations.

So we think the costs of competition are way overstated, and the benefits are substantial.

Let me turn finally, before I get to enforcement, why we're against a single worldwide standard-setting body. Three reasons.

One, it's not realistic politically. I don't think there's a snowball's chance in hell that Americans are going to eliminate FASB and all of a sudden embrace rule-setters in London. I just don't see it happening.

Number two, even if we got one monopoly standard-setter in London, who is to believe that that one monopoly standard-setter is going to be any faster moving or is going to write rules that are any better than GAAP? Over time it seems to me the same political pressures that are being brought to bear on FASB will be brought to bear in a different form in London. So a monopoly standard-setter does not solve the problem.

Finally, if you get a monopoly standard-setter we think there's a significant danger of fragmentation. They'll write very general rules, which is the main advantage of the International Accounting Standards, and there will be pressure by Americans and perhaps by people in other countries to have special interpretations, if you will, about what those rules mean for their individual companies in those countries. And the more interpretations you get, the more languages you get, and pretty soon you're back to a world with multiple standards. So we don't think a monopoly solution is a stable solution.

So let me conclude with a couple of observations on enforcement. How do we get auditors to do their job better?

Well, we have a lot of proposals out there and one of the great mysteries is why the current system hasn't done a better job. Currently we do have laws, criminal sanctions against companies that commit fraud. We do have liability. And there are criticisms, for example, of recent legislation that was passed in 1995, the Private Securities Litigation Act, claims that somehow the liability standards were weakened and that's the reason why the accountants haven't done their jobs.

George and I and our co-authors don't buy that. The fact is that the '95 Securities Act did not exempt accountants from liability, just ask Arthur Andersen. And all those other companies that you see in Table 1 in your list, almost every one of those cases the accountants are being sued. So the real mystery is why the liability system, frankly, hasn't done a better job of scaring auditors into doing their jobs. George is going to talk about perhaps several of the reasons why that may be true.

In the mean time it seems that we need, and we argue that there ought to be more finely calibrated incentives and sticks, if you will, to keep auditors toeing the line.

The popular proposal here in Washington is to create an agency, yet another agency to oversee the auditors. It's called the Public Regulatory Board. It was enacted in one version by the House and the Senate I think is going to take up the issue today.

George and I and our co-authors do not have any quarrel with there being more intensive federal oversight of auditors. But our main beef is why are we creating another agency? Why shouldn't this be the job of the SEC? And if the SEC doesn't have enough tools or enough money and there aren't enough sanctions or enough penalties, then Congress should simply create more penalties and more authority for the SEC to do its job.

We frankly, and we've scratched our heads trying to figure out why we're creating another agency. We think the SEC ought to be in charge.

The second point that we make is that you need the proper incentives for the auditors to do their jobs, and as long as the auditors are hired by the management of firms, there is always a danger that auditors will compromise in an effort to keep their business. This is true even if you require rotation of auditors, which some people have suggested. If you require rotation of auditors all you're going to get is a beauty contest every three or four years and you can still have managers favoring certain auditing firms in order to get their business.

So we think the ultimate solution is not to have the managers hire and fire the auditors. It ought to be another organization or another entity. We've surveyed all the choices and we come down on the side of those who have said that it ought to be the audit committees of Boards of Directors that choose the auditors. This is not a provision that was passed in the House bill. It is in the Sarbanes bill, and it's one element of the Sarbanes bill that I think we would be comfortable with. It's also, by the way, in a proposal that's been offered by the New York Stock Exchange.

We have some other points in the book which I won't bore you with now, but basically there are some broader issues beyond Enron and beyond WorldCom having to do with the way we treat intangibles, with the way we accommodate accounting to the new world of the internet and so forth. These are previewed in Chapter 1 of our book, but for time's sake I'll skip those issues right now and let George take you on a quick tour of Enron.

MR. GEORGE BENSTON: Thank you.

I have to say on a personal note that when I got into accounting as a CPA, I got out of it and did a PhD in Economics because it was so boring. Who knew that it would get to be this interesting, that people would actually be here to hear about accounting? So I'm glad I didn't cut my ties entirely and keep up my certificate.

The Enron is very interesting as a springboard, but it's not the only case, as we now know and as in fact those people who have done research in this knew for some time.

Let me go over a few of the Enron accounting problems to indicate to you that in fact there isn't any real reform necessary because what's happened in the case of Enron is they simply didn't obey the rules that already existed, so the question is why have new rules? What you have to do is enforce the ones that we already have.

First there's the question of the special purpose entities and these are simply organizations that can be partnerships or corporations that are set up in order to do something for a company like take receivables off the book and finance them in a different way. They've been around for a long time. There's nothing particularly wrong with them as such. The real criticism came because 97 percent of it was financed with debt and only three percent with equity. But under the Generally Accepted Accounting Principles if a company doesn't have at least one share be above 50 percent ownership of a company they can't consolidate it. They don't own it so they can't put it in with their own books. That's perfectly fine. The European procedures say if you have control, and that's probably a preferable procedure.

But the point is that except in one or two instances when Andersen realized that the three percent rule — I'm sorry, there's a subset that the SEC put in that said if the outside equity wasn't at least three percent then you could consolidate it. In a few cases they violated that and they did consolidate it later and made a big change.

What's the problem with that? Well the problem wasn't the consolidation because in fact the rules were that they shouldn't have done it anyway. The real problem was that where you have an entity where there's not an arms-length transaction situation, namely where it's totally independent, then you account for it differently. Again, that's an old accounting rule. The problem with Enron was their CFO, Chief Financial Officer Andrew Fastow, controlled and ran a number of these special purpose entities, or his employees did, and therefore there wasn't an arms-length relationship between them and the accounting is such, and it has been the case for the long time, that you can't book gains when dealing with an entity that you control because you can make them whatever you want to make them. They did that. That was a mistake.

The second mistake was conflict of interest. Where these are existing, and they did in this case, they have to be disclosed. Again, that's already in the rules. Financial Standard No. 5 requires that when there is a guarantee, a financial guarantee, that it has to be disclosed in terms of what the process is, what the amounts are and so forth. They didn't do that. That again just violated a rule that already existed.

Had they disclosed the amount that Enron was going to be contingently liable should the special purpose entities not be able to meet their obligations, that would have given analysts who cared to look and others the realization that there was a great danger that Enron would be subject to a lot of debt. But that's true in general.

Many corporations, many people are contingently liable for debt. That is something may happen and then all of a sudden they have to pay. That has to be disclosed. That's in the rules now. The question was why weren't the rules followed.

The major consideration with respect to that is the other reform was the way they dealt with the accounting of them in terms of, as I say, conflicts of interest, and whether they used fair value accounting. I'll get to that in just a moment. But mostly the SPEs as such were not a problem, it's just that they didn't follow the rules that already existed.

The major problem was that Enron involved itself in a number of transactions where they increased the value of their assets and showed them as gains and it looked as if they were doing very well. A lot of these were situations in which they were dealing with themselves. In some cases they had obligations in which the special purpose entities had an option to compensate Enron if these things should lose value. The problem was that the way Enron was compensated was with its own stock. So they were guaranteeing themselves, which doesn't make any sense. That should have been disclosed and in fact it shouldn't have been allowed in terms of showing that there wasn't a loss on Enron's books when it did indeed occur.

In several cases, and a big problem with fair value accounting is that they marked up various kinds of securities, or what they securitized these, and raised them based upon management's idea of what these things were worth. Well, management's idea of what they're worth is what management would like them to be worth. There were cases in which they had sham sales. I'll trade my million dollar cat for your million dollar dog and we each put it on our books as a gain and we put the asset on our books as it if it's worth that.

The accountant is supposed to look at that. That's old accounting. When I taught basic accounting we taught that in Accounting 101. That you don't do that, that you don't allow that sort of thing to be done. The key to accounting numbers in our opinion is whether they are trustworthy, namely whether people can believe that the numbers are there and they're not there to fool investors into thinking they're something they're not. That was one of the major problems.

The major problem with fair value accounting, and that's the only aspect of GAAP or GAAS, that is Generally Accepted Accounting Principles or Generally Accepted Auditing Standards, is that they now require, the FASB and the International Accounting Standards as well, has required companies not to market — that's fine, if there's an actual market price. But to mark to what they believe the value of these assets are and to show the gain as an increase in their profits for the year. That's the problem.

The problem is where you don't have an actual market transaction, something accounting has traditionally been based upon for a very long time, then we're not sure what that number really is. And where you have situations, and apparently there have been quite a few, where the managers would like to show that they haven't done as badly as they in fact have done, or would like to show that they've done better than they did do, there's a great temptation to write things up and show them as gains when in fact there aren't any real gains there at all. That's something accountants have always been concerned about and should be concerned about. The problem with fair value accounting is it gives managers the opportunity to do this and it's very difficult, even when the accountants want to control it, for them to control it because who knows how much something is really worth until there's an actual market transaction, it's bought and sold independently in the marketplace.

Therefore we would basically require and go back to the traditional accounting procedures which is to say you cannot record a transaction as having resulted in a gain unless there is an actual trustworthy number, an actual market transaction that's occurred in an arms-length situation such as you can believe the number. That's the key point.

The question was GAAS or Generally Accepted Auditing Standards violated? Yes. Because under the standards as they now exist and have for some years the job of the accountant, the independent auditor, is to be skeptical, is to always question management. Not to abet management into doing what it wants to do, but to question whether what they're doing is in accordance with what investors and others have reason to believe is going to be disclosed, namely that they are following the Generally Accepted Accounting Principles and in a manner consistent with those used in previous years. That's the general procedure that's used.

The problem is the auditor should always be aware, and I think most auditors are aware that there's a great incentive on the part of managers to try to change those numbers to look better than they really are, at least in the short run. So that is a big problem.

The question is, therefore, what went wrong? Why didn't this happen? Is it specific to Enron or is it a general problem such that we can't trust anything?

We looked up some of the research and there has been quite a bit of research done. There's a very good book by Chuck Mulford and Gene Comiskey on the "Financial Numbers Game" that was just published in which they go through in the last five years or so a whole series of restatements of accounting questions, of situations in which the numbers were wrong, and we've gotten a few more since they published their book, they can't keep up with it. What went wrong?

Well basically most of the things that went wrong were the same old, old things that have gone wrong for a long time. Sales that never occurred. Booking sales that in fact don't meet the Generally Accepted Accounting Principles for a sale, namely there's been an actual market transaction, a change in ownership, and a receipt of an asset that can be valued in exchange for the goods that's being sold. There were many situations in which there were false sales, sham sales, trades of goods that didn't have any market price, booking goods that were shipped but not billed, billing in advance of the actual transaction, all kinds of things.

We've recently seen the situation in which current expenses were capitalized, that is shown as assets and not as reductions of revenue. That's been contrary to what you're supposed to do in accounting as long as I can be aware and I think it goes back a hundred years, a long time. So it's not as if we need new rules. We have the rules. The question is why do people violate them?

There's another study done by the Executives Institute in terms of restatement. It looks as if there's been a great increase in restatements than there were. A lot of this was due to the fact that the SEC changed the way it treated restatements. It used to be that they would say that where there are relatively minor things you'd write them off over future periods. Now they insisted on having the last several years, since Mr. Levitt was Chairman of the SEC, having these written off by restating the previous statement. So a lot of this situation was is there a crime wave or is there just a change in how we report crime? A lot of it is a change in how we're reporting it. It's not as bad, I think, as it seems to be except that we've had some very big, very well known companies where things have been done wrong.

The major question is why did that happen? By looking over the things that did happen, I do have to wonder as an accounting professor why the partner in charge of the audit allowed it to happen. These were just basic accounting, the things you're supposed to look at, the things we teach our students, the things you should know if you pass the CPA exam. Where were the incentives of the firm to not stop that?

Those of us, most of us, the things I've written in the past, I've always thought it was in the enormous interest of the CPA firm to see that this didn't happen by their local partners in charge because as we just saw with Andersen, it destroyed the entire firm. This is a firm in which one office, the Houston office, did this and there are thousands of Andersen people around the world who did nothing wrong at all and yet they're all being destroyed by this thing. So why didn't Andersen stop this from happening? Couldn't they see that it was a possibility? I don't know the answer to that.

One indication may be that they took on consulting work and were afraid to drop it. But that isn't a very good answer because in fact consulting work has been done for a very long time. And further than that in the case of Enron the auditees were certainly sufficient to suborn an auditor if that's what it took to do. There was $29 million in audit fees, that's a lot.

So where the problem is I think, is that the individual partner in charge has an enormous stake in keeping that particular client. Namely that person is going to lose his or her major source of income and maybe [inaudible] as well.

My next question is, given that the individual partner has an incentive, even though the firm may not, the individual person has to go to accede to the demands of management to do aggressive accounting or do things you shouldn't do or not do as good an audit as you ought to because they might lose the client, the question is what can stop this from happening?

One thing I would have thought the SEC would have done over the years because there's another very good study done by Beasley et al for the AICPA a number of years ago looking at all of the fraudulent statements that the SEC said existed, and yet virtually no accountant was ever punished as a consequence. The question is why not?

I would hope that as a minimum they should be barred from practicing before the SEC. I would like to see their CPA certificates taken away from them if it's because of unethical and unprofessional behavior. But I think it's that kind of aspect, putting an incentive on the part of individual auditors that they personally will pay the price should they not do their jobs well because there's an externality here. That is not simply that they are damaged or their firms are damaged, but as we see the entire profession is damaged, and the American investor who is not sure anymore whether they can look at a statement and understand what they say and believe what they say are damaged. So there's a public policy issue here that I think can be and should be addressed.

If it hadn't been for the fact that the SEC was established in 1934 what we'd be doing right now would be saying let's create an agency to do all of this. We've got one. It has all the power to do this. I guess our question is why haven't they done it? And rather than point the finger at them the question now is why don't they do it? They have the resources. They give most of the resources they collect back to the Congress, that is to say back to the Treasury Department. They ought to be allowed to keep whatever they need to do the job correctly and not tax investors and companies any further than they're already being taxed and fees rendered on them.

Let me pass it to Katherine because I want enough time for all the rest of you to talk and think about this.

MS. KATHERINE SCHIPPER: My thanks to Bob Litan for giving me the opportunity to comment on his forthcoming monograph that's co-authored with George Benston who's with us here today, Michael Bromwich and Alfred Wagenhofer. They sent me Chapter one and that's the same materials that you have. I don't know what's in the rest of this monograph so I can't comment on it.

In making these comments today I need to tell you that the views that I'll be expressing are my own views and don't represent positions of the Financial Accounting Standards Board. Positions of the Financial Accounting Standards Board are arrived at only after extensive due process and deliberation.

I was pleased to see that Bob Litan said he wasn't here to put the FASB out of business. I'm here to say that I'm not going to try to argue that the FASB should stay in business. My comments are going to be restricted to just two elements of what's in the first chapter.

The first element pertains to the solution to the criticisms that the FASB is too slow, that it issues overly complex and ineffective standards, and the standard-setting process is too politicized by narrow interests. By that I believe that Mr. Litan means auditing interests.

There are several solutions that have been proposed to this and the one that Mr. Litan emphasized is competition. Other solutions that have been proposed go under the name of principle based standards. Some of them are themes, favored themes that are alluded to in Chapter One. The financial reporting model is too backward-looking, it omits non-financial information, it's inattentive to forces of globalization, and pays insufficient attention to the power of the Internet. I'm not going to talk about any of that stuff. That's the usual suspects in terms of criticizing the financial reporting model. I'm going to go right at the competition solution.

I'm also going to talk about George Benston's criticism of fair value accounting and let me start with that.

Fair value is a measurement attribute. In accounting that means it's a way of arriving at a number to record in the financial statement once it has already been decided that accounting recognition is appropriate. So in accounting, the distinction between recognition, the decision to record an item, and measurement, the attribute to be used, is really quite important.

There are a lot of measurement attributes out there. For example, acquisition cost is a measurement attribute that's quite distinct from fair value. Fair value is defined in U.S. GAAP in terms of exit values. Now an exit value in accounting is the amount at which you could sell an asset or the amount you'd have to pay to settle an obligation. So it's essentially the amount at which items would leave the financial statement, sales of assets, settlement of obligation.

As George Benston pointed out, the first best approach to get to a fair value would be to observe transaction prices in an active market. So if we're talking about shares of stock, for example, an active market might be the New York Stock Exchange.

There are also a variety of active used asset markets for relatively homogeneous goods. That's the first best approach. You look at active markets.

The second approach, and this is the one that George Benston criticized, is used when observed transaction prices are not available. Under those circumstances management estimates a fair value. That is management estimates the amount at which an asset could be sold or a liability could be settled using some kind of model and some kind of forecast.

Now George Benston described this in some fairly pejorative terms, and he said things like what management wants it to be, what management would like it to be. But I've given you a fair value objective. The objective is what is the settlement price for liability, what is the sales price for an asset. That's not what management would like it to be. So if management performs a measurement or a calculation that comes up with a number that is not an objective estimate, a good faith estimate of a settlement value or a sales value, that's a subversive implementation of the concept of fair value.

In other words, it's not a statement about fair value, it's a statement about how fair value is implemented.

Given these difficulties in implementation, why do accountants, some accountants, obviously not all accountants, why do some accountants favor fair value? The debate is far too complicated to go into here, but let me give you two basic views. View one is that for certain commercial arrangements fair value is the only measurement attribute. There is no acquisition cost. So either the item is not recorded, it's not recognized, or it's recognized at its fair value. An example would be an interest rate swap which is merely an agreement to exchange fixed for floating interest rate payments. Such commercial arrangements abound, they are not viewed as controversial. They have no attribute other than fair value.

The second reason to use fair value is the drive for relevance. Because commercial arrangements are increasingly characterized by long-lived transactions, that is transactions that take a long time to close and are incomplete through a number of accounting cycles, and because commercial arrangements increasingly take the form of multiple attribute arrangements, it is sometimes necessary to think about the following question. Do I want to wait until the transaction is over before I give it accounting recognition and measurement, or do I want to use an estimated number to come up with a measure in the financial reports of an incomplete transaction?

So if, for example, I enter into an arrangement that has duration 20 years, and during the 20 year duration of this arrangement I have no measurement attribute other than fair value, do I wait until the arrangement settles in 20 years or do I provide an intermediate or incomplete transaction measurement using a fair value?

We can see here that the drive for relevance, that is the drive to record some of these incomplete transactions in the financial reports collides with the demand for reliability and verifiability. It's a tradeoff that is settled in different accountants' minds in different ways. Some like Professor Benston are very concerned about the measurement error that is inherent in these fair value measures; others emphasize the relevance that is associated with coming up with an appropriately objective measure of fair value.

The only other thing I want to talk about is competition. The chapter of the monograph that I was given refers to the FASB as a monopoly, notes the FASB is slow, developed overly complex rules, highly technical rules, subject to excessive political influence, and recommends as a cure for this competition and Mr. Litan laid out four types of competition.

My understanding of the recommended form of competition is to allow preparers of financial statements to choose from two or more reporting systems and then to use the chosen system without reconciliation in any jurisdiction. I'll make several observations about this.

The first one is that although I cannot be sure that I have properly understood the description of the competition that is intended, if I have properly understood it, it sounds a lot to me like the existing arrangements on London's ISE, International Stock Exchange. So dispassionate observation of the functioning of this exchange would potentially provide some information about the benefits and costs of these arrangements.

Second, proposals for competition place relatively less weight or emphasis on comparability than the Financial Accounting Standards Board does. Now this isn't to say that the Financial Accounting Standards Board is right and Mr. Litan is wrong, it's only to say that your views about competition may be strongly influenced by your views about the importance of comparability.

Mr. Litan points to the possibility that analysts would be getting into the business of preparing reconciliations so as to put financial reports prepared on a disparate basis on a comparable basis. He pointed out in Chapter One of the monograph but not in his remarks that the necessary data to do these reconciliations may not be available. There will be measurement error in these reconciliations, and by the way, that is a cost of the system. In other words, the analyst would not do this for nothing. It would be a cost. So keep that in mind when I talk about costs and benefits of competition.

Turning to cost. I don't have any evidence that people like to pay for accounting, and I have some evidence that they don't like to pay for accounting. So let's talk about cost here.

If there's more than one standard-setter then somebody has to pay for more than one standard-setter, and somebody has to pay for the enforcement of more than one set of accounting standards.

This is not to say that this is a cost that is unbearable or it's a cost that is too large. It is merely to say that two standard-setters means to sets of standard-setting costs and the necessity for enforcing two kinds of standards.

Finally, I guess I don't really understand what Mr. Litan means when he talks about competition or what is intended. When I think about competition in its easiest form I think about winning profits by getting others to use my products and services. For example when I was a professor at Duke University we used to think about competing for students. We wanted to get students to come to Duke's program and pay Duke's tuition money. We would like to take the best students away from our competition.

Financial accounting standards aren't like that. You can't sell them. They're more like a public good, more like. They're not a public good but they're more like a public good.

For example, the Financial Accounting Standards Board is not collecting fees by the intensity of use, so we don't have a licensing arrangement whereby we collect some amount of cash every time a user accesses one of our standards. If we did then we could certainly talk about competing to sell more uses to one of our standards.

We also can't exclude non-purchasers. Once a financial accounting standard is issued, anybody can use it. We might be able to say well, we've got some copyright protection on the actual pages, but the exclusion of non-purchasers I'm talking about simply means that if everyone in this room uses financial accounting standards, it doesn't keep everyone in the rest of the building from using financial accounting standards. There's no congestion cost here.

There may also be some network externalities. The more people who use the standards the more robust the interpretations and the easier they become to use.

So when Mr. Litan and Professor Benston talk about competition I don't know how to drop it into my understanding of the way standard-setting actually works because we don't actually sell these ideas. We don't sell them.

It may be that they have something in mind like the alleged competition for corporate charters that exist in the state for the United States where it is noted that Delaware has quite a few corporate charters, provides excellent services to those who consume corporate charters and charge a fee for this. So if they have that kind of model in mind what they must mean is devising a funding mechanism where the FASB and the IASB could be like Delaware. That is charge a sort of fee-for-use notion and then compete over inducing users to consumer more IAS standards or more FAST standards.

I note on prescient that when Mr. Litan points to what he described as excessive political influence on the FASB, the European situation already has the apparatus in place for both technical and political oversight of International Accounting Standards. While this technical and political oversight have not yet been exercised, the possibility exists — and I mention this only as a possibility — that what he describes as political interference in accounting standard-setting could be at least as extreme in Europe as it is in the United States given the apparatus that's in place.

Finally, I want to remind you once again that I'm not here to defend the status quo in terms of setting accounting standards. I agree with the criticism that U.S. GAAP is voluminous, complex, and difficult to retrieve. I agree with the criticism that the current four-part standard-setting apparatus that includes the FASB, the Emerging Issues Task Force, the ACSEC of the AICPA and the SEC, is cumbersome and could benefit by streamlining. I agree that the due process of the FASB is slow, cumbersome, and does not always reach an outcome that pleases all constituents.

Therefore, speaking only as an individual, I would say that I welcome scrutiny of the FASB and believe that the entire standard-setting apparatus in the United States does deserve scrutiny and improvement.

Thanks so much.

MR. HAHN: I'd like to ask Professor Benston or Dr. Litan if they would like to respond to Dr. Schipper's concerns about competition and standard-setting.

MR. BENSTON: I think Bob should respond to the competition in standard-setting, and I'll just mention about the fair value accounting very briefly. I think her remarks are excellent and she laid out the issues very well in terms of measurement and relevance.

The point that we make and I think is an important point is that what is relevant in terms of an audited financial statement is that it be reliable. If investors want to know exactly what a company is worth, they're not going to find out from accountants. No matter what they do. There are all kinds of things we simply cannot measure. If accountants knew how to measure that we'd be incredibly rich and we wouldn't have to worry about teaching accounting any more or doing accounting.

The problem is accounting numbers are useful for investors to make decisions and they have been. They're also useful to know whether somebody's ripped off the company somewhere and you don't know whether the stuff's still there or not. So the auditing is very valuable.

The problem basically is that while we'd like to know how much something is worth, until there's been a market transaction we usually don't know. To be specific about Enron they booked as gains ten year contracts, an electrical contract that they securitized as if they knew what the present value of the cash flow was worth. Nobody knows. And in fact it turns out they've been wrong. They booked enormous gains in their contract with Blockbuster when the whole thing was only about two weeks old and their auditors for some reason allowed them to do that.

The question is what I hope people would want, that financial statements which may not be right in the sense that they are what the economic value of assets and liabilities are, but they're not deliberately designed to mislead you. They follow a set of rules that you can understand and disregard if you don't think the number useful.

For example, they put a number down of how much a building costs. That isn't what it's worth today. How much is it worth today? Nobody knows. There's no point trying to tell people that we do know when we don't know.

So the question really is what I think is relevant and suggest to you is relevant is the number you can trust, at least understand, may not be what you want. You better go out and get the numbers from somewhere else. I think that's a very valuable thing for accountants to do. When we stray off that path we have real problems, I'm afraid.

MR. LITAN: Just a couple of comments. I think Katherine laid out the issues very well, and the issue of competition.

There is a tradeoff between comparability, being able to have apples-to-apples comparisons and the benefits of competition that we just come down on the side that there are benefits to competition.

If you grant that the monopoly process of setting standards does have the problems that Katherine referred to — slowness, excessively detailed rules, and I think frankly the largest problem is excessive political influence — I think FASB on its own in principle could cure the first two problems. Slowness and complexity. In principle. I don't think they could ever by themselves cure the political influence problem. There's no way. If Congress wants a rule stopped, it's stopped.

We come to the conclusion the only way to offset the weight of political interest — and by the way, it's not just the auditing profession. In the case of a stock option rule it was corporate America and specifically the high tech community which killed the stock options rule.

The only way you're going to offset that is to have the marketplace make a judgment as to whether or not the rule is a good one or a bad one. It seems to me that if we had investors saying look, a set of standards that doesn't have expensing of stock options, if it doesn't have that we're going to punish companies that pick that standard.

Katherine makes one final point that I want to talk about and that is what's the incentive for FASB and the International Accounting Standard setters to compete with each other? After all, there's not money at stake. This isn't like a real competition.

At the end of the day, yes there is money at stake because if one set of standards increasingly becomes irrelevant, then whatever funding mechanism is in place whether it's voluntary or mandatory, will be put in jeopardy. People are not going to want to throw money after a set of standards that are irrelevant. That raises the second point.

I don't think Katherine and people that are of such high quality that now serve on FASB would want to be on FASB if their standards become irrelevant. If we run a race and it turns out that only two percent of the companies choose FASB and 98 percent choose International Accounting Standards I think there will be an incredible pressure eventually to have FASB fold, and I think the people at FASB would resist that. So I think yes, there is an incentive for the two to compete with each other.

In fact the main criticism I think of the competition rule is that two bodies is not enough. You may only get a duopoly, and you really need more competition. But here is the problem. If we had five or six or ten standard-setters, then Katherine's point about comparability becomes a real problem because the more bodies you have the more problems you have with reconciliation and the benefits of having the competition in relation to the cost get a little more iffy.

So we'd like to at least see some more competition than what we have now as a way to get the ball started.

MS. SCHIPPER: In terms of your remarks on competition, the Financial Accounting Standards Board and its oversight body the Financial Accounting Foundation and its trustees have made a public commitment to what accountants call convergence with International Accounting Standards. Convergence means that the FASB is committed to working with the IASB to achieve a single set of high quality standards to be used in all political jurisdictions. Therefore the commitment of the FASB's oversight board, the FASB and the IASB is to a model that is very different from the one that Mr. Litan is proposing.

You may say well why would you do that? The FASB is probably working to put itself out of business in the long haul because if there is one international standard-setter I assure you it will not be located in Norwalk, Connecticut. It will be located in some location that represents its international, its global flavor.

When will that be? I don't know. Probably not any time real soon. But in the mean time the model that you're proposing is not the model that has been adopted by the standard-setters worldwide.

MR. LITAN: Agreed, and we just agree to disagree.

MR. HAHN: We'd like to hear from you. If you could raise your hand, wait for the mike to come around, stand up and identify yourself.

QUESTION: Hi, I'm Perry Quick from one of the final four. [Laughter]

Professor Benston, your comments about fair value accounting, I agree with what you're saying and your concerns, but how would you operationalize your alternative to fair value accounting or your improvement in it?

MR. BENSTON: Essentially it's to return to what I think accounting has done for a very long time, and that is to look at reliability, at trustworthiness in terms of the numbers. Such that if there isn't a market transaction that you can rely upon, an arms-length price that you can pin something on to, that you simply say this is what it cost us and this is how we've allocated it over time, and we'll know what its value is when in fact there's a market transaction.

MS. SCHIPPER: So Professor Benston, how would you then, or wouldn't you, give accounting recognition to derivative instruments that have no acquisition cost?

MR. BENSTON: Again, if we get into the 800 pages that the FASB has come up with plus CDs to tell people how to use it, I'd say it would be much better not to do it than to do it that way.

MS. SCHIPPER: So Professor Benston is alluding in what I hope is a semi-humorous way to the authoritative guidance on accounting for derivatives which consists of one standard and quite a number of pages of implementation guidance. Implementation guidance is the accounting terminology that describes answers provided by the FASB or another standing organization to questions asked by constituents. So this is, I guess I'll call it response to constituent request for information about implementing a standard.

The actual accounting standard for derivatives isn't all that long and it would be considerably shorter, by the way, if it were not riddled with exceptions that were put in place because of constituent requests.

It's the implementation guidance that talks about how the scope exception is or isn't widened and how to carry out some of the very specific calculations that are called for. I think what Professor Benston is saying is that he'd rather see no accounting recognition for derivative than the existing accounting recognition.

MR. BENSTON: Essentially I would go back to, and I think what has served accounting very well for a very long time, which is the matching concept which says we first recognize revenue when we have objective evidence that the revenue has been earned, and then we match expenses to that revenue. And when we can't record the revenue because the objective evidence doesn't exist, then we defer the expenses if they have future value. That is to say if they are not completely used up or there is no value. With respect to derivatives it means simply that you don't record the economic value of a derivative as at the end of a period. I think that's very useful not to do it for the simple reason that the value of derivatives change so rapidly that by the time the financial statement is produced anyway, it's out of date. So people, we can disclose what's been done and we expect that the analysts and others who are trying to get at it will try to understand what the firm is doing now as against what it may have done three months ago and what the derivative position was.

MS. SCHIPPER: You've now introduced a new element and that's the periodicity of financial reporting. I believe that what Professor Benston was saying is that under statutory requirements in the United States for quarterly financial reporting we would get a new fair value measurement at best every three months.

Now Mr. Litan is on the record, along with some others, as recommending a significantly shortened periodicity. As we shrink the periodicity, suppose just to take a hypothetical, that we were to go to one month's financial reporting. That's just a hypothetical. That would mean that every 30 days you'd get an updated measurement of the fair value which is significantly more often than I look at my own stock portfolio these days. [Laughter]

MR. BENSTON: I think the kind point is what do we expect from accounting? What do we want from it? What we'd like to get is that if we get all the economic values instantly at all times. We can't do that. It's too costly even if we could do it, and secondly, we can't do it. And if we did do it, as you put it very well there's a tradeoff between numbers that are reliable and numbers that you'd really like to have. Economic values, as I know you know, are subjective. They're present values of expected cash flows which are very difficult to measure and are necessarily measured subjectively. Accounting, the quest for that type of reliability, for giving people numbers that they'd really like to have I think is the big mistake that accounting has allowed itself to slip into.

What we do as accountants is very very valuable. It's very necessary. I don't think anyone would buy stock if they didn't know that the books were audited by an independent public accountant who's responsible for his or her work.

What I think we've done, and maybe since people have gotten very involved in investing is wanting more from accounting than they can deliver, and the consequence is that it delivers something that people are then very upset about.

QUESTION: My name is Douglas Cruner and I'm from the Congressional Budget Office.

Mr. Litan, I heard your comments twice today on the accounting for stock options and you referenced them in your topic on competition. You stated a hypothetical example where there would be a choice between a GAAP standard and an IAS standard for accounting for options and you speculated that companies choosing the GAAP standard, that is to not expense options, would be punished in the capital markets.

I disagree with what you stated and I'd like to tell you why that is. The current accounting pronouncement for stock options already gives that choice. FAS 123 gives companies the option to expense options or the option to not expense options. And in the S&P 500, 498 of the companies have chosen not to. They've chosen the intrinsic value method.

With that in mind, those companies have not performed as well as many of the other companies in the S&P 500. When you look at the technology companies in particular, their overstatement of earnings by not expensing options is quite high and they've been rewarded in the markets. Up until the tech bubble burst, we saw them being rewarded by investors and I'd like to hear your comments on that.

MR. LITAN: That's a fair point. I think the questioner pointed out that under the current rules companies have a choice now as to whether to expense stock options or not and almost all of them are not expensing stock options.

But the competition that we're talking about is a world, let's say — which by the way doesn't exist yet and we're only speculating. But suppose we go to a world where companies can choose International Accounting Standards or the U.S. GAAP and the International Accounting Standards do require, not give an option, they give a requirement for expensing of stock options and the American system, the GAAP system, still has a choice and it's all voluntary.

I suspect that in such a world, which again does not exist, you'd have a lot more companies, especially worldwide, that would be reporting under International Accounting Standards. If those standards say expense stock options and American standards do not, or at least don't have the requirement, I think there would be more competitive pressure than exists right now. And we haven't run that race yet. All I'm saying is, and I think the first chapter makes this point. It doesn't say that this brave new world of competition would necessarily force the correction. It's just that in a world of monopoly standard-setting there is no ability to counteract the current political forces right now which impede the requirement of expensing stock options.

If you have a better idea, I'm all ears to try to figure out a way to offset this political influence on FASB. But I've racked my brain. I cannot think of a better way to offset the political influence problem and to have at least some chance for market-based competition.

QUESTION: Two points. George, your suggestion about stock options seems inconsistent with your criticism of fair value accounting. These stock options are not tradable, they're basically contingent liabilities that are not tradable, but you want them to be expensed but not other contingent liabilities that are not tradable. So I think that's an inconsistent position between your general criticism of fair value accounting and your assumption somehow that it would be better to expense options.

Second, there is a study that looks at the effect of the difference between accounting standards. In the German New Market they permit firms to use either IASB or GAAP, and the study finds no difference in bid/ask spreads and other measures of that nature.

So at least in that market, which is somewhat like the NASDAQ market in the United States, in the set of firms that are listed on that market there doesn't seem to be any difference in the standards.

MR. BENSTON: I'm aware of the study, and it's a good study so I have no quarrel with that. But basically there's been actually not a lot of difference. I did a point-by-point analysis of IAS and U.S. GAAP. There's not much difference between them. One of the major ones is the one we're talking about which I don't think is very relevant to German companies so it just doesn't come up there because they don't do that.

In terms of the other aspect, there's a big difference between German GAAP accounting and International Accounting Standards and in that the study found that there International Accounting Standards seemed to be better in that sense.

So I don't know that that particular study will answer the question that we're talking about although it was a nice piece of work.

Insofar as your first point is concerned, you do raise a very good point. I'm going back to the traditional accounting model. The traditional accounting model is that you first recognize revenue, and for that you need objective evidence. Then to that you match expenses where you sometimes don't have objective evidence.

Namely the whole thing about the stock options is very simple. It's an expense. You hire a CEO or any other officer and you give them something of value and something of value that you've given, and you may have to estimate what it's worth, but it's still something of value. You have to make a choice between showing it as an expense against the income that is currently recognized or deferring it in some future period when it indeed is exercised. There's always a tradeoff in that. As Dr. Schipper said, there is a tradeoff. There's no absolutely correct rule here.

My tradeoff — not mine, I'm sorry. But I think the accounting tradeoff over many many many years has been get trustworthy numbers. Even if they're not relevant in the sense that you know what the economic values are and let the people who use the financial statement supplement these with numbers that they will get from other an better sources, but at least they can trust the numbers they get from the accountants.

QUESTION: But your standard seems to be inconsistent between revenues and expenses.

MR. BENSTON: That's right.

QUESTION: You would not recognize contingent revenue, but you do want to recognize contingent liabilities.

MR. BENSTON: And that's because again the accountants have I think quite correctly, and they've lost their way now in changing it, have realized that what people get very upset about is if you tell them they've got something and it turns out they don't have it as against you understate. So we have a conservative bias in accounting. We tend to put off, we recognize bad news and we tend to put off the good news until we're sure we have it.

There's GAAP which is very important, and there's CYA which is just as important. [Laughter]

QUESTION: My name is Mortimer Kaplan. I'm a lawyer, predominantly a tax lawyer, but I do serve on several Boards and I serve on audit committees. I want to make two points.

One is you talk about standards not being the problem, and yet we've been discussing a number of the standards already. I'd suggest that your treatment of that is a little cavalier. I think that standards do have to be examined.

My more important point is this question of the audit committee. I've been serving on corporate Boards for 20-some-odd years, I've been on audit committees most of that time. Everybody seems to think the solution is the audit committee. Legislators, the media, you're doing this right now, the pending bills. I'd like you to look at the realism of the audit committee. Most of them are fairly busy people. They're capable people. They can't go through all the details that are being thrust upon them. They are not the solution. They need experts to advise them.

I've just served on three audit committees, I am serving on three audit committees right now and we had to select new accountants, new CPAs. Two of them actually had used Arthur Andersen before and had big successes. The amount of work that went into that was just almost intolerable. We had to lean on management very much. It really was unrealistic to expect people who understood finance, who understood corporate management and the like to make this selection without leaning heavily on the managers. The same thing with many other aspects of putting on the audit committee.

I recall that former Justice Arthur Goldberg when he left the Court served on the Board of TWA and he resigned when he was asked to vote upon the compensation of top executives. He thought he was not fully informed. They needed some outside help. He would like to have independent lawyers, independent accountants, independent experts of one sort or another. Now layer upon layer upon layer. I just don't think the audit committee is the answer.

MR. LITAN: Let me comment.

First on the issue of standards, were they at fault and so forth? Yes, we've been talking a lot about the standard-setting process. But our major point, at least so far in the book, is that if you look at all those accounting standards of recent vintage, the lion's share of the problem was not the standards, although at the same time we're saying there are problems in the standard-setting process. But we want to make the point that that is not the main problem that you see in the newspapers.

Second point on the issue of the audit committees. You're making a very good point and I've heard this from other members of audit committees. They say you're putting too much work on us and you're expecting too much.

We surveyed all the institutions that can hire and fire the auditors and do the watchdogs. All right? If you think about it, do you want the SEC to do this? Hire 12,000 — There are 12,000 public companies. Do you want the SEC to pick auditors? I don't think so. Do you want the New York Stock Exchange to pick auditors? I don't think so. And we had an extended discussion of all the practical problems. Do you auction off the rights? How many firms at once do you consider in doing the auction? There are all kinds of nightmarish problems.

Then you come back to well if you're not going to have third parties do the hiring and firing and we're not going to have management, that leaves the audit committee. Now that is essentially where the New York Stock Exchange came up. Yes, we're going to put it on the audit committee and you know what? We're going to make it a harder job. We're going to make it a quasi-full time job. You're going to have to meet I think 12 times a year with management, with the internal auditor, with the external auditor, four times each times three is 12 times, plus they'll probably have to have to have caucuses.

So the bottom line is that being a member of the audit committee is going to be a much bigger deal in the future and you'll have to pay them more. You won't be able to pay them, I think according to the New York Stock Exchange, in stock. You'll have to pay them in straight cash. It's going to be a real job, and it's not going to be the job of the kind we saw before and all I can say is compared to all the alternatives, it's like democracy. Who is it, Winston Churchill said compared to everything else, you know, democracy's the best you've got going. It's I think the best option we've got going. We'll just have to make it a tougher job.

QUESTION: Steve Graysdorf, Director of Co-Initiatives for Business. This question is mostly for Ms. Schipper.

Investors are becoming as concerned about social and environmental issues as the numbers themselves. I wonder to what extent is the FASB involved in establishing standards for social and environmental accounting.

MS. SCHIPPER: The FASB is currently not at all involved in establishing standards for social and environmental accounting. There is a long history behind this.

When the financial reporting model, when those who think about the financial reporting model stuck the toe ever so slightly into the waters of something other than financial statements, and that was with the AICPA special committee headed up by Edmond Jenkins, the report came out in about 1994. The notion that standard-setting, financial reporting standard-setting, getting outside the financial reports in any way, even as close as non-financial indicators of performance, was soundly rebuffed, soundly rebuffed. So I can imagine what would happen if it were extended in the direction that you're speaking of, social and environmental matters.

The existing accounting for environmental obligations is an access document from the AICPA so there is authoritative guidance for environmental cleanup obligations basically but it didn't emanate from the FASB, and indeed I would be greatly surprised if our constituents wanted the FASB to extend its purview beyond the financial statements. Given what happened when there were discussions of matters like order backlogs, which is actually kind of close to things that are in the statements now, that was not viewed favorably, so going in the direction that you're speaking of would probably be viewed even less favorably.

Again, I emphasize that I'm giving you my opinion about this. I'm not giving you the FASB's opinion, nor am I talking about what could happen two years from now. It's a description of the current arrangement.

MR. BENSTON: I'd just like to mention that when I was at LSE I temporarily held a chair and they said I had to give a lecture and my lecture was on exactly that subject. The tag line was that the social responsibility of accountants is not to do social responsibility accounting. The reason is that what you're trying to do is inherently impossible, and for an accountant to lend his or her name to that and say this is what the social responsibility of the company has done or not done is to take the reputation of accountants and to use it for public relations in a way that would be detrimental to accountants and to the meaningfulness of the numbers. You should recognize that when any company gives you a number, don't trust it and go do your own investigation. I think accountants would do better not to lend their name to that kind of thing because they don't know how to do it.

MR. LITAN: Or to put it another way, they're having a hard enough problem doing the numbers they've got.

MR. BENSTON: I'll send you a copy of the paper if you like.

QUESTION: My name is Gary Barlett. I'm Manager of Tax, Finance and Accounting Policy at the National Rural Electric Cooperative Association. This question is for Mr. Litan.

As you laid out the two problems, the standard-setting process and the enforcement problem, under the enforcement side of course you noted that some have suggested that a public regulatory body, oversight body, be part of the solution on the enforcement side which I think you indicated you scratched your head about as it related to adding an additional layer to that that the SEC, or we already had the structure there to do that. But then on the other side, on the standard-setting process, by introducing competition your solution to the comparability issue was to introduce a third party independent industry to address that. So it seemed to be contradictory. It seemed to me that maybe working with the FASB to work out their problems would be consistent with your solution on the enforcement side, unless the political side is driving what you suggested there.

So I guess my question is, from a consistency standpoint would it be better to maybe work with FASB to do that or not?

MR. LITAN: First, on the issue of enforcement, the real question is we have a body of rules, a body of law, and in other contexts, let's not talk about accounting. Let's talk about the criminal law or the civil rights law or the antitrust laws or whatever, actually antitrust is not a good example because we have two enforcement agencies, but let's take criminal laws or whatever. We typically have a governmental agency in charge of enforcement and it has a monopoly. That's sort of what we define as a state. And we have one outfit that does this. Our only question really in the case of accounting is why have the agency that theoretically is supposed to enforce the nation's accounting and disclosure system, why have it contract out its job to somebody else? We don't have the Justice Department contracting itself out to trust us or let's enforce crime, let's go against criminals, but yet we seem inclined to create another agency or a quasi-public body to enforce laws, and we just don't see a case for contracting out. So that's on the issue of enforcement.

Then it comes to the issue of accounting government-setting. All I think we're saying is recognizing Katherine's point that there is a cost to introducing competition in terms of comparability, and I will concede that there may not be perfectly comparable numbers, and even a third party industry coming into existence that will try to do the reconciliations won't have access to all the numbers. It's still, in our view, better to have the competition because it probably is going to do a better job of curing the slowness, the complexity and the political influence problem than relying on magic to cure it by itself.

MS. SCHIPPER: I guess I have a little trouble understanding your analogy between criminal laws and auditing standards. Auditing standards in this country are not statutes. They're not statutes. Therefore, you wouldn't really want to have a statutory body that got into the business of setting auditing standards. It strikes me as not a productive use of legislators' time. But if you had a private sector entity that was accountable to a regulatory agency like the FASB is accountable to the SEC and the proposed regulatory body would be accountable to the SEC, you would sort of delegate this rulemaking to a group of people that were more or less paid to do it with defined due process. Very important. Were accountable to their constituencies in important ways and you'd get away from this notion of statutory ideas. It strikes me as efficient. Relatively efficiently.

MR. LITAN: My reply to that is don't get hung upon the issue of statutory or non-statutory. Let's take environmental rules or occupational safety rules. We have an agency or agencies to set those rules which in principle are no different than accounting or auditing standards, and yet the agency that sets the rules also enforces them. I just don't see why an agency should just contract out completely the enforcement of rules. I just don't see the case for it.

QUESTION: One criticism I've heard of regulatory — Sorry. I'm Jigni Sprite. I'm a recent graduate from Georgetown Law Center.

One criticism of regulatory competition is that it creates the risk of a race to the bottom among the regulators, and this is especially true where you have international regulators who are found to be less accountable to constituents. Is there evidence that large money managers or other interest groups have enough influence on corporate management or audit committees to push for the selection of the best regulator?

MR. LITAN: Will there be a race to the bottom if we get competition in standards? I think the best evidence is what happened after Enron. We saw what the marketplace did and investors did to companies that investors didn't think were disclosing enough. They got hammered. They were all-star companies — GE, IBM, AIG. Their stocks got hammered until they came out with more information. So I think there is evidence from very recent times that the marketplace will enforce a competition upwards rather than a competition downwards.

MS. SCHIPPER: The research on whether state chartering of corporations in the United States has led to a race to the bottom where one would hypothesize that Delaware since it has so many corporate charters would be bottom doesn't support the view that there is a race to the bottom in corporate chartering in this country. Persons who are observers point to the high quality of the Delaware Chancery Court, the predictability, the speed that's associated with those adjudications and say that this is really quite a high quality place to have your corporate charter.

If we try to move that over to the accounting world we founder once again on the fact that when Mr. Litan talked about the competition that would ensue or might ensure between the FASB and the IASB it's not like the competition among the states where Delaware can actually charge you money directly if you want to be incorporated there. He said we would be humiliated if others chose the IASB and high quality employees would exit the system. All true, I suppose, but not the same kind of competition so I'm not sure about drawing that analogy. And the individual from the Congressional Budget Office has already talked about the use of non-expensing of stock options under SFAS 123 by 498 of the Fortune 500.

QUESTION: Hank Broner, Rowen and Blewitt. We're corporate governance consultants.

Is it possible, this is a question for the panel, is it possible that the market is already healing itself? The New York Stock Exchange has very vigorous rules that they're about to adopt including audit committee hiring of auditors. The NASDAQ has rules, S&P has its new core earnings, Institutional Shareholder Services has a corporate governance quotient. Are these factors likely to set aside Sarbanes' bill or other congressional action or White House action or SEC action?

MR. LITAN: I'll give you my own view. I think what you call self correction is probably not only a fact, it's probably going to do most of the work in fixing all these problems. There will be a lot of blood on the floor along the way, but yes, I share your working assumption.

We're going to get the Sarbanes bill or something like it. We're going to get probably tougher penalties for misconduct and so forth but that will be the icing on the cake. I think the cake is what you pointed out. There's an enormous amount of self correction.

MR. BENSTON: Not only is there self correction as we're seeing, but there's a tendency to look at the instances because they're so well publicized and the news if it bleeds it leads, and big companies who are well known are going to get a lot of attention. But we have about 12,000 registered companies. It's not true for the overwhelming number of these, when the Financial Executive Institute, or International I think they now call themselves, did a study looking at all instances in the years that they looked at, I think it was '77 through '91, I think, they found really very few instances in which you had these problems.

They've increased in the last few years, but part of it is that people are now doing things, restating their financial statements where in past they'd have just written it off over the future period instead of going back and restating. Part of it was the act of the SEC in looking at people who seemed to be manipulating their financial numbers to meet the one cent rule, namely you've got to meet whatever the analysts say you're supposed to make. Why anyone pays attention to that is beyond me in that sense. One of the things I hope everyone realizes is accounting is far from an exact science. Any manager who wants to can manipulate the financial numbers and there's nothing anyone can do about it. You can just put off repairing your factory, you can delay R&D, you can not advertise, or you can — all these things are just absolute expenditures which will change your reported net income and no one can say it's wrong. Maybe it's a good business decision.

So the idea that you can't manipulate in some manner, you being the executive, the net income to some small extent is not only true, but it's always going to be true. To expect perfection is just to get lies because it's not going to happen.

So we shouldn't be emphasizing the exact amount of earnings in every one period as if it were a number that has exact meaning. It doesn't.

MR. HAHN: I just want to follow up on that question and ask our panelists, in your view do you think we need additional legislation? And in particular you mentioned Sarbanes and a few other people. Do you think that's likely to do more good than harm if it passes?

MR. LITAN: I think if the Sarbanes bill passes it won't do more harm than good. I think there are some beneficial features in the Sarbanes bill. By the way, I'm speaking personally now, not on behalf of all the authors. I think especially the fact that it's going to have the audit committees hiring and firing auditors, I think that's a very good feature of the bill. Both George and I and all of us do not think we need another agency. We still think the SEC ought to do it, but as a second best alternative if we end up with something like the PRD and it has these powers, that will, in my view that will be a net improvement.

The President tomorrow is going to talk about, in a widely anticipated speech, tougher criminal penalties as a solution to all of this.

My only view about this is, and Congress by the way may well go along and make it a very long term offense to cook the books. My only caution is that after all the furor over the legislation dies and people move on to the next subject, I think you'll see very very few criminal convictions for accounting misadventures. These are damn hard cases to prove, unless you want to lower the standard of proof, which I don't think at the end of the day Congress will approve.

The standard for going to jail will have to be just like it is in other areas of criminal law, a very high standard with criminal intent, intent to deceive, all kinds of things, and as George pointed out there is so much discretion built into accounting that I think even having all kinds of additional penalties, it will look good politically but as a practical matter it will be very hard to throw corporate executives or their auditors in jail for this kind of stuff.

MR. BENSTON: I think I'd add it will also be very difficult to get people in Enron to disgorge anything they may have gained, because in Texas your homestead, which can be anything, is exempt from bankruptcy law. So there has been a lot of enhancement of personal property in Texas at the moment.

The other thing, I should also say that I'm only speaking for myself in what I'm about to say. My remarks should not be construed to be those of the Coca Cola Company since I'm from Emory University and we are very highly supported by them.

One piece of legislation I hope they do pass, and that is to require that all audit committees have an accounting professor on them so that we can enhance our income. [Laughter]

Very few of them, by the way, use professors on these things partially because I think we're loose canons and they don't want us there. [Laughter]

Jadicke [ph] was out of accounting for quite awhile. He was retired. We want it for those of us who are still working. And economic professors.

MR. HAHN: Katherine, do you want to say anything about that?

MS. SCHIPPER: You mean do I want to comment on Professor Benston's suggestion that accounting professors — [Laughter]

MR. HAHN: No, additional legislation.

MS. SCHIPPER: Thank you, no.

QUESTION: I'm Pete Chetley from Brookings. I'm not an accountant, have never had an accounting class. But I'd like to broaden this question, this subject a little bit. You're saying the problem would be to give the police departments of the country more tools with which to catch criminals. My question to you all is why not look, and maybe you do in your book, why not look at the perpetrators in the first place? Isn't that where the problem is? These corporate executives that are doing these things. Why just make it easier for the accountants to catch them? Why not shine the spotlight of something on them and put the focus and the onus on them to correct these so the accountants don't have to spend all their time catching the perpetrators?

I'm thinking back to Watergate where after Watergate the legal profession said maybe there's a weakness in our profession and we need more ethics rules or something in our law schools. And the words ethics and morality never came up here in the corporate behavior.

MR. LITAN: We're not excusing them because first, there are already laws right now. If you mislead and you're a corporate exec, you get sued. Now as I said, what the President's going to add tomorrow, I think, is that corporate CEOs have to sign a statement swearing that all the numbers are okay, and that gets to the issue of criminal penalties. If somehow the CEO purposefully misleads then the CEO goes to jail. It would be something like that.

My only point was that I don't think you'll see many CEOs go to jail. You can write a law that says that, but it's going to be damn hard to convict people of things like that.

So you have to think about what other things can you do to make CEOs behave? One thing, for example, would be and we haven't talked about it, is back to expensing of stock options. If we have more disclosure of stock options and if we had shareholder approval of stock options, grants and so forth so there was more sunshine in the process, then that would help provide some additional scrutiny. Those are my own personal views.

MS. SCHIPPER: It would seem to me that directors' and officers' fiduciary duties, that is the duty of care and the duty of loyalty capture a great deal of what you're talking about. If one is an officer or director of a publicly held entity in the United States, in all the 50 states that I'm aware of, you have these fiduciary duties to your shareholders. Clearly, knowingly promulgating false reports would not be acting in the shareholders' best interest. Clearly. So there's an argument that an officer or director who takes his fiduciary duty seriously would not misbehave in the way that some of these individuals have been alleged to misbehave. Either being breathtakingly careless and ignorant of what's going on, or in some instances the allegations are they willfully and knowingly misled.

So I think the focus is very much on those duties. We happen to be talking about accounting up here because, well, what did you think I would talk about as an accountant, and because that was our subject matter. But of course if you want to go into these other directions I'd be delighted to.

MR. BENSTON: I think I would emphasize the accounting, though, because the accountants — I mean the external auditors — are the gatekeepers. They're hired because there is a concern that maybe the managers will not report things that they don't want their constituents to see. After all, if you're sure nothing will go wrong, if you're sure everyone will do everything right, then who needs an auditor? The auditor's there because there's a possibility that in fact somebody, maybe on a lower level is stealing, on a higher level is reporting something incorrectly or in ways that are intended to deceive, or is covering up mistakes that they've made that they don't want people to know about. That's why we have auditors. The auditor's job is to actually try to find those things. Not with perfection, because the cost of perfection far exceed any benefit that we're likely to get out of it. An actual investor can have a portfolio of stock, some of which will go bad. Remember, the investors are going to pay for all of this. They're the only people who are going to pay for it. One way or the other.

The question is what happens with the auditors who in fact don't do their job? And I have to say as a CPA I'm very upset at some of the things that I have seen with Enron and I don't know, I haven't looked at their books, I haven't looked at the audit, but I have been an expert witness in a number of cases against auditors and they did lousy jobs and they should pay the price. Our students have to pass a CPA exam when they want to be CPAs and they have to maintain their proficiency in order to keep that certificate. I take it very seriously.

MS. SCHIPPER: George, I think you're being, perhaps placing too much weight on one element of the financial reporting process. The process starts with the FASB and the other standard-setting bodies in the United States, and I take very seriously allegations that parts of our standards are defective, need to be relooked at. We won't go into which ones those are, but those accountants in the room know what I'm talking about. So at the beginning of the process we have the standards, we have the implementation guidance, and then we have the effortful, cognitive process of implementing those standards. That's a management responsibility. It's management's job to know and understand the authoritative guidance, to apply it to events transactions and commercial arrangements that emanate from that firm's business model and to produce the financial reports. That's the process. The auditor enters at the end.

It's inappropriate in my view to expect the auditor to inspect in quality that should have been put there at the very beginning. There's too much pressure on one part of the process. The pressure should be evenly distributed across the entire process going back to my job at the FASB and that standard-setting continuing all the way through to the end.

MR. BENSTON: I agree with you. Obviously what you're saying is very well said and there's certainly nothing to disagree with, but let me use an analogy. We have laws that say you're not supposed to rob people. It is the job of the legislature to pass such laws. It's the job of the crooks, people, not to deliberately try to steal from other people. But it's the job of the police to try to make sure that if somebody steals they get caught and try to prevent them from stealing. My concern is with the police. Namely, they're hired — If I find a policeman who's doping off in a corner and not watching, not doing his beat, then I'm really down on the cop. I grant you the crook shouldn't be a crook and the law should prevent that, but the police, namely in this case the auditors, their job is to see that the other people are doing what they're supposed to do. At least to the extent that it's economically worthwhile, which isn't to say perfection. No one's life is at stake, where the police have a different situation.

QUESTION: Julie Coster with National Journal.

In many of these cases you've suggested that the powers are in place, police powers are in place and the SEC for inexplicable reasons didn't use them. What we've seen in this round of restatements so it seems is that all the checks and balances, various checks and balances failed when they were needed. So one can talk about police action after the fact, but it's a kind of costly way to have the markets readjust. There are huge dislocations in jobs, in people's expectation about their retirement and their portfolios. So the question is whether you can put in place any preventives that can withstand a huge run-up in stock prices.

My question in part to you is do you think that 9/10ths of the problem here is that the money being tossed around and the opportunities for wrongdoing were just so lucrative that none of these systems would have really ever made any difference and that we just have to, we're kind of doomed to a cycle of boom and bust on these things? Are there some long-term changes in the nature of the market or the participants, the fact that there were so many small shareholders coming in now and changes in the compensation system for CEOs? Is there something long term and structural that's changed about the market that suggests that we are in for more trouble or have to approach our problems differently? Or is this just a boom/bust thing where we just have to get used to big dislocations every now and then when the market catches up with the wrongdoing and the money, the incentives are finally gotten so far out of whack?

MR. LITAN: It's a great question and I think people will be writing dissertations about this for at least a dozen years. We have speculation in the current version of our second chapter, and that's all it is is speculation, that why is it that all of a sudden we get these big companies with these big CEOs that seem to have gone over the edge? You'd think that the liability laws would deter them, criminal laws or whatever would deter them. This again is speculation on our part, but certainly I think the movement toward incentive base pay, performance base pay with executive compensation tied to the stock market while in general is a good idea, because you do want to pay for performance, it probably had a number of people that took it to the edge and over the edge so that's probably why we're getting more of these bigger companies doing this kind of thing than let's say we did in the 1980s.

What do you do about all of that? You don't ban executive base pay. What you do is more disclosure, and they have more shareholder approval, more market scrutiny. But what we're seeing right now is a massive correction that's responding to whatever it is that drove these people over the edge. The questioner before who said that a lot of the correction is self-correction, it's the market working. The market punishing companies that went over the edge. The New York Stock Exchange. Even FASB had record change in its rules on special purpose entities. We have a lot of things that are happening even without legislation and we're going to get some legislation. Keep our fingers crossed that it won't all be overkill.

So I think when all the dust settles that we'll be better off, with one caveat. That is we're going to throw more money at the SEC and I personally have no objection to that. I think we ought to have more scrutiny by the people who are supposed to police all of this. But in the short run, with more money at the SEC to look at corporate statements, we may even have more injury statements, right? We'll have more cops with more money. We may find more crime. So in the short run we may end up with more companies on the front pages of newspapers and that could have, at least in the short run, negative connotations for investors.

In the long run, investors should be comforted by the fact that we've had all these changes and more money at the SEC, more cops and so forth, but this problem may not be, or this pall that's currently hanging over the market may not be lifted any time soon until we get past this sort of bloodletting press that we're in the middle of.

That's a long editorial comment.

MR. BENSTON: I would just add that we're pinning an awful lot on accounting as having been responsible for these things. Think of the dot.com runup and rundown. Accounting had nothing to do with that. Accountants did not account for intangible assets, thank goodness, because then they'd be blaming us for having overstated what all of there assets were worth what it turns out they weren't worth.

In the case of Enron one of the biggest runups in Enron stock was when Mr. Skilling announced they were going to engage in this new broadband activity with Blockbuster. Stock I think went up 20-26 percent in one day. No accounting had been done. They hadn't recorded it as anything. People were estimating what they thought the future was going to be and they mis-estimated. The accounting had nothing to do with that at all. And by the way it's not simply happened this year. It happened in the 1920s and it happened throughout history. People are trying to estimate what the future is worth and whether they can get onto this thing before the stock goes even higher or they can get off before it goes lower. That's what stock speculation, if you like, or purchases are all about. That's why those of us who study it simply have a diversified portfolio because we don't think we can do it.

MR. HAHN: Dr. Schipper, any final remarks?

MS. SCHIPPER: I think what Professor Benston is talking about is failed business models cause business failures. The reason that accounting comes into the mix of this is that financial reports, which are not representationally faithful, and in the extreme we have a fraudulent financial report, they provide unreliable signals for resource allocation. So investors continue to invest in the failed business model because they don't know it's failed. Sooner or later of course the business model does fail, accounting only postpones the inevitable along these lines, but the wealth losses that we're speaking of are larger than they would have been if it were only the business model. The fact that accounting was allegedly used in some of these circumstances in a way that created not representationally faithful reports caused investors to continue to invest even though the business model was not working. And you and I are in agreement on that.

MR. BENSTON: Yes.

MR. LITAN: On some things.

MR. BENSTON: On most things, I think.

MR. HAHN: We are out of time. I want to thank you, the audience, for asking some pointed and excellent questions of our panelists, and I'd like you to join me in thanking Dr. Schipper, Professor Benston and Dr. Litan for a very informative presentation.